Mergers

1. Mergers Economic Issues Miguel A. Fonseca m.a.fonseca@exeter.ac.uk

2. readings • Martin, S. Industrial Economics, ch. 10 • Church & Ware, ch. 23 • Motta (2000) – available online on the course website.

3. Recap • Last week we started the class by looking at two extreme cases: • Perfect competition: • “Atomistic”, price-taking firms, free entry and exit and perfect information. • Firms set P=MC • Monopoly: • One firm, no entry, firm sets price to maximize profits (Q=(a-c)/2b)

4. Let’s meet in the middle: Cournot competition • Neither perfect competition nor monopoly are realistic models of the world; it’s best to think of them as benchmarks. • Most markets have a relatively small number of firms that compete for a share of the market. • Unlike PC, it is reasonable to assume that what a firm does has an impact on what its rivals do.

5. Cournot • Firms maximize their profits, given what their opponents do: • If all firms make the same quantity decision simultaneously, we find that the equilibrium output is equal to: , where

6. Cournot (cont.) • From the expression above, it is easy to see that if n=1, we have the monopoly output • Also, as n -> infinity, the output produced by all the firms approaches the PC output (and price). • Consequently, this means that as n rises, so does CS. Also, DWL goes down.

7. Mergers in a Cournot setting • So, what happens if there is a merger in a Cournot market? • The model basically says that if firm A buys firm B, it basically shuts that firm down and works as if it did not exist.

8. Mergers in a Cournot setting • The merger has different impact on the different firms: • The merged firm reduces output; • The unmerged firms increase output. • Essentially, in this framework, mergers merely result in reducing the number of competitors in the market. • Is this realistic?

9. Differentiated products • Firms often sell differentiated products. • E.g. 1: Sports cars (Ferrari, Porsche, Bentley…) • E.g. 2: Clothing (Prada, Gucci, Dior…) • This means that some consumers may prefer a given product, even if it is more expensive. • If two companies merge, they will have a larger portfolio of products with which to compete.

10. Limited capacity • A firm may not be able to serve the entire market, even if it charges the lowest price. • Let M be the total number of consumers and assume each consumer demands one unit of a homogenous good. • Let K be the sum of individual firm capacities ki, where k1<k2<…<kn and M>ki.

11. Limited capacity • If M > K, competition is not effective and firms charge monopoly prices. • If K-n > M, any (n-1) firms can cover the whole market, so we have pure Bertrand competition. • If M > K-n, equilibrium takes the form of Edgeworth cycles.

12. Motivations for mergers • Entry deterrence; • Increasing capacity; • Expanding product range; • Gaining market power; • Lowering costs through synergies; • Larger firms will have easier access to capital; • Speculative motives.

13. What are the effects of a merger? • Unilateral effect • Lower number of firms leads to an increase in market power. • This will then lead to a rise in profits. • Measures of market power and concentration: • The Herfindahl-Hirschman index: • m-firm concentration index:

14. What are the effects of a merger? • Coordinated effect • Merger may facilitate collusion • Why? • With a smaller number of firms in the market, collusion is typically easier to sustain. Deviations from the agreements are easier to identify. • A merger may give rise to a more symmetric capacity/market share distribution. Collusion depends on the ability to discipline firms into sticking to the collusive outputs/prices; if one firm is too large, the other firms cannot punish it for breaking the agreement.

15. Merger policy • Section 7 of the Clayton Act regulates merger policy in the US. It is loosely based on the degree of concentration in both pre- and post-merger markets. • A merger will be challenged if: • Post-merger 0.100 < HHI < 0.180 and ∆HHI > 0.010 • Pre- and/or post-merger HHI ≥ 0.180 • Other important factors are: • Ease of entry; • Economies of scale; • Degree of foreign competition; • Profitability of pre-merged firms.

16. Merger Policy • The Rome Treaty regulates merger policy in the European Union. EC Merger Regulation states: “A concentration which creates or strengthens a dominant position as a result of which effective competition would be significantly impeded in the Common Market (…) shall be declared incompatible with the Common Market” • No objective criterion on which to analyse a merger, unlike the US.

17. Case study: Nestlé-Perrier merger • In 1992, Nestlé, a player in the French bottled water sector (Vittel and Hepar) notified EC commission of the intention to purchase Perrier SA. • In 1991 the bottled water market had an annual volume of 5.25 billion liters and 3 major firms: • Perrier: 35.9%; • BSN: 23% • Nestlé: 17.1% • A large number of very small local producers: 24%.

18. Nestlé-Perrier merger • In order to avoid EU regulatory concerns, the two merging firms had agreed to sell Volvic (a major mineral source of Perrier) to BSN. • They argued that the post-merger market would become a balanced duopoly: • (Nestlé + Perrier – Volvic)’s market share: 38% • (BSN + Volvic)’s market share: 38%

19. Nestlé-Perrier merger • The EU Commission opposed the merger on various grounds: • Two main players would be of similar size and nature; • Cost structure is similar costs; • R&D’s role is minor; • Monitoring each others’ prices is easy; • Demand for water is relatively price inelastic; • High barriers to entry. • In short, the potential for collusion is very high.

20. Nestlé-Perrier merger • The Commission rejected the simple merger on the grounds of establishing a dominant firm with too much market power (Unilateral effect). • It rejected the merger with the sell-off of Volvic for fears of establishing “oligopolistic” dominance (Coordinated effect).

21. Nestlé-Perrier merger • Nestlé proposed to the Commission an alternative which involved: • Selling Volvic to BSN; • Selling off a variety of its brands (Vichy, Thonon, Pierval, St Yorre, etc), as well as 3 billion liters of water capacity to a third party. • The Commission accepted this solution.

22. Nestlé-Perrier merger • What would the outcome have been had the merger taken place in the US? • Likely that they would have been rejected as well, since HHI>0.180.